Certain S corporations get relief from GILTI double tax

| 9/24/2020
Certain S corporations get relief from GILTI double tax

On Sept. 1, the U.S. Department of the Treasury and the IRS issued Notice 2020-69, which notifies taxpayers that regulations will be published to allow certain subchapter S corporations to elect to be treated as entities for purposes of the global intangible low-taxed income (GILTI) under Section 951A. This entity treatment will provide shareholders of eligible S corporations with relief from potential double taxation that results under the final GILTI regulations published in 2019. The notice also provides that S corporations don’t have to wait for regulations to be published to take advantage of the new rules.

Background

Under the 2019 GILTI regulations, S corporations are treated as foreign partnerships, which means S corporations must use the aggregate method for taking into account GILTI attributes and allocate those attributes to the S-corporation shareholders rather than computing a GILTI inclusion at the entity level and distributing the inclusion to its shareholders. Under the aggregate method, GILTI is not an item of income to the S corporation that is distributed to its shareholders. Instead, the S corporation allocates each shareholder a pro rata share of GILTI attributes (such as tested income, qualified business asset investment, tested interest income, and expense), which the shareholder then uses to compute its own GILTI inclusion.

Because the S corporation does not have an entity-level income event with respect to items allocated under the aggregate method, the S corporation does not increase its accumulated adjustments account (AAA). This could result in double taxation to the S-corporation shareholders in certain situations. For instance, when an S corporation makes a distribution to its shareholders to pay taxes that arise from taking into account the GILTI attributes, that distribution is tax free up to the amount of AAA, limited by basis. If there is no AAA and the S corporation has accumulated earnings and profits (AE&P) as a result of previously being a C corporation, the distribution is considered as coming out of AE&P and is taxable as a dividend. Therefore, if an S corporation with AE&P that has exhausted its AAA makes a distribution to its shareholders to pay their tax on their GILTI inclusions that arose from attributes passed through the S corporation, its shareholders are subject to additional tax on earnings that already have been subject to tax.

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Relief provided

The notice provides that forthcoming regulations will allow an S corporation with AE&P as of Sept. 1, 2020 (considered “transition AE&P”) to elect entity treatment with respect to GILTI. As a result of this entity treatment, the S corporation would compute a GILTI inclusion at the entity level and allocate a portion of this amount to its shareholders. In their returns, shareholders would include their distributive share of the S-corporation GILTI inclusion.

The GILTI inclusion would be an item of income of the S corporation and would increase the S corporation’s AAA. Consequently, the double taxation issue described earlier would be eliminated. The drawback of the entity election is that any S-corporation shareholder that does not independently qualify as a U.S. shareholder of a controlled foreign corporation (CFC) owned by the S corporation, and that otherwise would not be subject to GILTI, would have a GILTI inclusion as a result of the election.

The entity election may be made on a timely filed S-corporation return for tax years beginning on or after the date of the notice (Sept. 1, 2020). For tax years ending before Sept. 1, 2020, and after June 21, 2019, the election can be made only if the S corporation and each shareholder consent to the election and the election is made with a timely filed or amended return filed before March 15, 2021.

Once made, the election is irrevocable. However, the election terminates on the date the S corporation no longer has transition AE&P. It is unclear whether the election terminates upon the S corporation ceasing to be a U.S. shareholder with respect to its CFCs or whether a new election would be required if it later becomes a U.S. shareholder.

Unless an election is properly filed, the default treatment for an S corporation with respect to GILTI is the aggregate method. S corporations without transition AE&P are not permitted to make the election and remain subject to the aggregate method for all calculations and reporting connected to GILTI. The notice leaves other questions unanswered. For instance, it does not discuss whether the regulations will allow S corporations without transition AE&P to make the election or whether they will allow an election to be filed later than March 15, 2021.

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Brent Felten
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John Kelleher
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